What are Private Equity Firms?

Private equity (PE) firms are known for targeting high returns of around 20.0% to 30.0% from their investments. This is achieved by making operational improvements, paying down debt, and, in some rare cases, multiple expansions. One of the main drivers of high returns is the total amount of debt that can be raised to finance the deal in the first place. The more debt the lower the equity requirement, which typically leads to higher returns – providing, of course, that the high levels of debt can be adequately serviced by the cash flows.

Maximizing Debt Capacity

The maximum amount a PE firm can borrow is determined by the free cash flow estimate. Banks and other lenders want to ensure the target company’s operations can easily afford any mandatory loan repayments on time and in full. This means that the free cash flow generated by the target company each year needs to be sufficient to pay the necessary interest and loan principal. If banks will only lend money for five years, this means that the maximum loan will be limited to the present value of the free cash flows from the first five years, discounted at the post-tax cost of debt. In order to borrow more, they need to tap into the cash flows from year six, seven and beyond.

Debt Tranching

The bank’s limit of lending for a maximum of five years severely restricts the amount that can be borrowed by the PE firm and would not allow them to achieve their required returns. In order to borrow more, they can look for other investors with differing risk profiles who are willing to lend to them for a period longer than five years, at a higher cost of debt to reflect the increased risk. For example, a mezzanine investor may be prepared to lend for six years and some high yield bond investors might be prepared to invest for seven or more years. These new investors are now bringing the year six and seven cash flows into play, increasing the debt capacity for the PE firm and ultimately improving the IRR. You can download the accompanying Excel file to see how this might impact the returns to the PE firm.

Different Debt Structures

The particular debt structure used in an LBO is determined by the market at the time of the deal. Prior to the 2008 financial crisis, banks might lend for up to eight years in three tranches, Term A, B & C, whereby the term A loan would amortize over six years, and the term B loan would be a bullet repayment in year seven and term C a bullet payment in year eight. On top of this higher cost, subordinated debt would be common, such as “second Lien” (with lower-ranking security), “mezzanine” debt, and high yield bonds which might be available for up to ten years. The loan tenure reduced significantly following the financial crisis making big LBO deals less attractive due to the lower expected returns. Despite the different market conditions, lenders would generally expect to be repaid within three to five years – when the PE exits the deal.
A relatively new loan structure is “Unitranche”, whereby the borrower (i.e. the PE firm) arranges to borrow through a single lender who could be a non-traditional lending entity, such as a debt fund. Behind this lender could be several other lenders with differing risk profiles and the loan is aggregated into one tranche. The borrower often has no visibility of how the individual aggregated loans are structured but this type of facility can be faster and more flexible than dealing directly with multiple lenders.